How Lenders Make Money Off Mortgage Borrowers
Interest is the money that lenders charge you for borrowing money and the way that they make the most money from a borrower over the life of a mortgage. For a $300,000 30 year fixed rate mortgage with a 4.0% interest rate a borrower will pay $215,610 in total interest expense over the life of the mortgage. That's a lot of money and the higher the interest rate the more money a lender makes from a borrower. For example, if you increase the interest rate to 5.0% for a $300,000 mortgage, the total interest expense over the life of the mortgage increases to almost $280,000.
Because interest is such a big cost to borrowers, you should pay very close attention to your mortgage rate and take steps to pay the lowest rate possible. Measures borrowers can take to ensure they are paying the lowest rate include:
Compare Lenders. Gathering multiple proposals and creating lender competition for your mortgage business enables you to negotiate the lowest possible interest rate. The table below compares mortgage rates and fees for leading lenders in your area. Contact multiple lenders to shop for your mortgage.
In addition to shopping lenders, there several steps you can take to lower your mortgage rate and total interest expense over the course of your loan.
Make a 20% Down Payment. Most lenders will offer you their best interest rate if you make a down payment of at least 20% of the property purchase price
Select a Shorter Mortgage Term. Mortgages with shorter terms have lower interest rates which can save you tens or even hundreds of thousands of dollars over the life of a mortgage. The flip side of a shorter mortgage is that the monthly payment is higher because you are paying back the loan over a shorter period of time
Pay Discount Points. A discount point is an extra fee borrower have the option to pay to lower their interest rate. If you are going to own the property you are financing for at least five years if may make sense for you to pay discount points to lower your rate. We go into more detail on discount points below
Taking steps to lower your mortgage rate requires extra effort by borrowers but can save you thousands of dollars over the life of your loan.
Lender fees are the numerous costs or expenses lenders charge borrowers to process their loans. Different lenders charge different fees and use different terminology but some of the more common lender fees include origination fees or points, administration fee or underwriting fee. Some lenders charge a single flat fee while other lenders break-out fees into separate cost items.
Please note that lender fees are only one component of total mortgage closing costs which also include third-party fees for the appraisal report and title services among other charges. In most cases the lender collects the fees for these third party services from the borrower and then pays the service providers.
Similar to getting the lowest mortgage rate, the best way to pay the lowest lender fees is to compare multiple quotes. By comparing mortgage proposals you may be able to negotiate lower lender fees or closing costs. One approach to lowering lender fees is to select a "no cost" or "no fee" mortgage. Although a "no cost" mortgage may seen appealing borrowers should understand that these program usually charge a higher interest rate than a loan with standard costs. Before you select a "no cost" mortgage make sure you understand what your interest rate, monthly payment and total interest expense is as compared to a loan with regular fees.
Lenders offer borrowers the option to pay discount points to obtain a lower mortgage rate than they would otherwise receive. A discount point is an upfront fee that equals 1% of the mortgage amount. For example, if the loan amount is $200,000, one discount point would cost the borrower $2,000. You can pay for discount points out of pocket or you may be able to add them to your loan amount, depending on what size mortgage you qualify for. It is important to emphasize that paying discount points is completely optional for the borrower.
As a rule of thumb, if you pay one discount point, it should lower your mortgage rate by .250%. For example, if you receive a proposal with a 4.250% interest rate and no discount points, this equates to a mortgage with a 4.000% interest rate with one discount point.
Because you recover the cost of the discount points over time by paying a lower mortgage payment, paying points typically only makes financial sense if you intend to own the property you are financing for more than five years. Five years is a sufficient length of time for you to recover the upfront cost of paying the points.
Use our Discount Point Mortgage Calculator to compare loans with different points and interest rates
A small part of your interest rate (typically .250% to .375%) goes to the company that services your mortgage. Servicing a mortgage includes collecting the monthly payment, ensuring you pay your property tax and insurance and generally managing the relationship with the borrower. From the borrower's standpoint, your loan servicer is the company you make your mortgage payment to.
In some cases your loan servicer is the company that funded your mortgage. In other cases the funding lender sells the servicing rights and possibly your mortgage to another company which then becomes your mortgage servicer. It can get a little confusing but all the borrower should really focus on is who you make your monthly payments to and who to contact if you have any issue with your mortgage -- that company is your loan servicer.
In short, the mortgage rate you pay includes a small spread above the market interest rate the lender charges you for borrowing money. From the borrower's perspective while it might be nice to know what the servicing spread is (so you know the actual market interest rate) the lender typically does not disclose that figure and it is already included the rate you pay. Plus there is no way to have to loan servicing spread removed. Because the loan servicing spread is already included in the mortgage rate, the best way for a borrower to find the lowest loan servicing fee is to find the mortgage with the lowest rate.
Service Release Premium
The service release premium is related to the loan servicing fee discussed above. In some cases a funding lender will sell the right to service a mortgage (and usually the mortgage itself) to another company. The lender that sells the servicing rights to a mortgage receives a fee called a service release premium. The service release premium is paid by the company that acquires the servicing rights and is typically 1.25% to 1.75% of the loan amount. Lenders will not typically disclose the service release premium to borrowers.
It is important to highlight that the borrower does not pay the service release premium but mortgages with higher interest rates and fees typically have higher service release premiums so in some ways the borrower indirectly pays for it. The best way for borrowers to avoid high service release premiums is to search for the mortgage with the lowest interest rate and fees.
Additionally, if your lender sells the servicing rights to your mortgage you will likely make your monthly payment to the company that bought the rights. When you get a mortgage ask the lender if they intend to retain servicing of your loan or if they will transfer or sell servicing to another company. That way you know where to send your payment and who to contact if you have any issues with your mortgage.
Late Fees and Other Penalties
The final way that lenders make money from mortgage borrowers is from late fees and other penalties. To avoid paying late fees borrowers should of course make their payment on time and consider setting up automatic payments from their bank accounts. Some lenders may even offer you a small interest rate or closing cost discount if you set up automatic payment for your mortgage.
Borrowers should also pay close attention to where they should send their monthly payment. As discussed above, your mortgage servicer, the company you make your payments to, can change over the course of your mortgage. In many cases you may make your first monthly payment to the company that funded your mortgage but make your second payment to a different lender who has acquired the servicing rights to your loan. Borrowers should be notified in writing if their mortgage servicer changes but it is ultimately borrowers' responsibility to send their payments to the correct address or even better, to set up automatic payments from their bank account.
Some mortgages may also include prepayment penalties if the borrower repays the mortgage in full prior to a specified period of time. Borrowers should avoid mortgages with prepayment penalties if possible
The Loan Estimate indicates if a mortgage has a prepayment penalty and also outlines the terms of the late fee. A lender must provide the borrower a Loan Estimate that outlines a good faith estimate of the key terms of the mortgage within three business days of the borrower submitting a loan application to the lender. You should use this document to fully understand all of the fees, charges and potential penalties for the mortgage.
Understand How to Use a Loan Estimate for a Mortgage
Mortgage Interest: https://www.consumerfinance.gov/ask-cfpb/what-is-the-total-interest-percentage-tip-on-a-mortgage-en-2001/
Lender Fees: https://www.consumerfinance.gov/ask-cfpb/what-are-mortgage-origination-services-what-is-an-origination-fee-en-155/